Major League Debtors Part II

"The ranks of BBB- credits are a lot like AAA baseball teams," we observed in last Friday’s Rude Awakening, "Both groups include ‘players’ that aren’t quite Big League material."

The BBB- echelon, which is just one downgrade away from "junk,"contains both tired, old has-beens like General Motors and brash up-and-comers like the Russian government. These two borrowers may both be BBB- "teammates" for the moment, but we doubt they’ll be on the same team for long.

When we peaked under the hood of General Motors last Friday, we were rather disturbed by what we found. The giant American automaker’s balance sheet strains under a towering $244 billion debt load, as well as growing pension and healthcare liabilities.

Thus, this once-and-former AAA credit seems to deserve every bit of its near-junk rating. By contrast, the Russian government had never managed to earn an investment-grade rating…until a few weeks ago. "Like a career minor leaguer," we noted last week, "the Russian government’s credit rating bounced around in the junk ranks for several years.

Then, in 1998, this troubled borrower validated its lowly rating by defaulting on its sovereign foreign debts."

Since those dark days, however, the Russian economy has clawed its way back to international respectability, finally garnering an ‘investment grade’ rating from S&P late last month.

Even so, does the government of Russia government really deserve the same credit rating as General Motors?

"Yes, indeed," Standard and Poor’s would cautiously reply. Late last month, the rating agency boosted Russia’s long-term foreign debt to BBB-. "The upgrade reflects recent, crucial improvements in the government’s debt level and external liquidity," says Helena Hessel, a Standard & Poor’s credit analyst. "These improvements are so significant that they now outweigh the serious and growing political risk that continues to be a key ratings constraint on Russia."

"S&P’s upgrade," the Moscow Times reports, "gives the country a prestigious triple investment rating for the first time ever after upgrades by Fitch Ratings in November and Moody’s Investors Service in October 2003."

Russia’s improving "income statement" and balance sheet would seem to validate the recent expressions of confidence in its credit-worthiness. Thanks largely to a "petrodollar" windfall, Russian economic performance has been improving dramatically over the last several years. GDP jumped about 6% last year to $600 billion – the sixth straight year of GDP growth above 4%.

Meanwhile, the government has enjoyed five straight budget surpluses.

"While some oil-exporting nations such as Venezuela have used windfalls from soaring crude prices to finance massive spending binges," the Wall Street Journal recently observed, "Russia – long a financial basket case – has transformed itself under President Vladimir Putin into a model of fiscal rectitude. The country has salted away billions of its petrodollars instead of spending them."

The former communist nation has amassed $124 billion of foreign currency and gold reserves – slightly more than the $113 billion it owes to foreign lenders. And Russia is retiring these liabilities much faster than most folks expected. The government recently announced, for example, that it will repay $3.33 billion in loans from the International Monetary Fund ahead of schedule.

These new realities aren’t lost on fixed-income investors. GM and Russia might both carry a BBB- credit rating, but the debt securities issued by these two borrowers do not seem to elicit a similar enthusiasm from bond buyers.

The nearby chart presents the yield curves of three "near junk" entities, relative to U.S. Treasury yields: An index of BBB- credits, Russia’s dollar-denominated foreign debt and General Motors’ debt.

Every gimlet-eyed reader will note that GM must pay the highest yields of the three. In other words, most bond investors prefer Russian debt to GM debt…and for good reason, we think.

"The [Russian] economy is growing for a seventh straight year," the Moscow Times reports, "driven by a consumer boom and high prices for Russia’s biggest commodity exports…That is a massive turnaround from 1998, when Russia defaulted on domestic debt and devalued the ruble, sending shock waves through world markets.

But Russia’s considerable economic achievements since 1998 reside in the annals of history. The future is what matters most to bond investors, and the future of the Russian economy may contain a risk or two.

"Little effective reform was accomplished in 2004," the S&P ratings team admits. "Attempts to reform the judiciary and public administration have been ineffective, the restructuring of the electricity sector has stalled, and the reform of Gazprom has been delayed. A further significant worsening of the domestic political scene, together with unsustainable economic policy decisions, would dent investor confidence and lead to rising private sector capital flight. This would weaken…potential economic growth and its strong liquidity position, which could negatively affect sovereign creditworthiness over time."

On the other hand, assuming oil prices remain firm and assuming Russia’s economic reforms continue – even in a jarringly Russian style – the economy should continue to flourish.

This up-and-coming financial phenom is not certain to become an all-star, but we would not dismiss the possibility.

Did You Notice…?By Eric J. Fry

Twenty years ago, who could have imagined that the Russian government and General Motors would share an identical near-junk credit rating? Who could have imagined either that GM’s credit standing would deteriorate so badly, or that Russia’s would advance so dramatically?

These opposing trends illustrate a fascinating macro-economic phenomenon: the poor are becoming richer, while the rich are becoming poorer. The Russian economy, like that of many developing nations, has been steadily improving, while the historically strong economies of the West have been gradually deteriorating.

As such, these trends illustrate a kind of "Beatitude Syndrome," in which the "first shall be last" and the last are rapidly becoming first.

"Credit-rating agencies can’t say enough good things about emerging markets these days," the Wall Street Journal reports. "Eight countries from developing Asia, Europe and Latin America secured upgrades in January…It’s not a one-month trend…Moody’s Investors Service has announced 50 sovereign upgrades since the beginning of 2002 and only 17 downgrades over that span – a sharp reversal from 1998, when it carried out 22 downgrades and just two upgrades amid the financial crisis and Russian debt default."

As a result of the upgrade binge, almost 45% of the weighting on the 31-country EMBI Global Index had achieved an investment-grade rating by the end of January, up from 4.1% a decade ago and 16% five years ago.

Meanwhile, America’s national finances are going from bad to worse. Not only is our savings-short economy absorbing $600 billion per year of the world’s savings to plug its current account deficit; not only is our government’s budget poised to operate in the red for as far as the eye can see; not only is the average American household shouldering a record level of personal debt; but also, many former American industrial powerhouses are succumbing to forces of financial entropy.

Excessive debts and inadequate cash-flows have a way of bringing down financial enterprises, no matter their pedigree or their past glories.

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About Eric Fry:

Eric J. Fry, Agora Financial’s Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling. Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant’s Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant’s International and Apogee Research, institutional research products dedicated to international investment opportunities and short selling.

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts. His views and investment insights have appeared in numerous publications including Time, Barron’s, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.